chapter ii consumption function: conceptual issues and
TRANSCRIPT
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
34
CHAPTER II
CONSUMPTION FUNCTION:
CONCEPTUAL ISSUES AND
THEORIES
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
35
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES
AND THEORIES
2.1 INTRODUCTION
A pertinent microeconomic question that each household faces is what part of their
income they must consume and what part must they save. The answers to this gives
insight into the decision making of individuals and a congregation of these responses
also has macroeconomic consequences. Households’ consumption decisions have
significant impact on the way economy as a whole behaves both in long and short run.
Consumption refers to the final purchase of goods and services by individuals or
households. A deep study of consumption is important for two significant reasons.
Firstly, consumption is a major constituent of aggregate demand and accounts for 58%
(Database on Indian Economy, RBI, 2014-15) of the aggregate demand and thus it is
important to understand what determines consumption. Secondly, income that is not
consumed is saved and savings have a huge bearing on the growth of an economy.
GDP of an economy as the name suggests is the sum total of goods and services
produced and the yearly growth rate of GDP is the major yardstick or benchmark to
judge the economic growth of the country. The major constituents of the GDP growth
are (a) Consumption, (b) Government Spending, (c) Investments (d) Net exports. Out
of all these factors responsible for GDP growth, consumption is dominant part
contributing to GDP growth.
GDP = C + I + G + (X-M)
where, C = Consumption, I = Investment, G = Government Spending, X= Export and
M = Import
This chapter is further divided into four sections. In Section 2.2, we will study Keynes
Psychological law of consumption, its propositions, determinants, assumptions,
importance or implications, its conjectures, empirical study including early empirical
“Consumption is the sole end and purpose of all production.”
- (Smith, 1776, p. 363)
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
36
study and Kuznets puzzle. Section 2.3 presents the reconciliation of short run and long
run consumption function, this section goes on to look at the drift theory of
consumption, relative income hypothesis, Irving Fisher hypothesis, permanent income
hypothesis and life cycle hypothesis. Further Section 2.4 studies the other theories on
consumption i.e. Robert E. Hall’s Random Walk Hypothesis and David Laibson Pull
of Instant Gratification. Section 2.5 will summarize the chapter.
Thus this chapter will focus on the theories as presented in Figure 2.1.
Figure 2.1 Consumption Theories
Source: Researcher’s own Compilation.
2.2 CONCEPTUAL FRAMEWORK OF KEYNES
CONSUMPTION FUNCTION
2.2.1 Concept of Consumption Function
The consumption function refers to income consumption relationship. It is a “functional
relationship between two aggregates, i.e., total consumption and gross national
income.” Symbolically, the relationship is represented as, C= f (Y), where С is
consumption, Y is income, and f is the functional relationship. Thus the consumption
Consumption Theory
Keynes Theory of
Consumption Drift Theory of
Consmption
Relative Income
Hypothesis
Irving FisherPermanent
Income Hypothesis
Life Cycle Hypothesis
Random Walk
Hypothesis
Pull of Instant
Gratification
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
37
function indicates a functional relationship between С and Y, where С is the dependent
and Y is the independent variable, i.e., С is determined by Y. This relationship is based
on the ceteris paribus (other things being equal) assumption, as such only income
consumption relationship is considered and all possible influences on consumption are
held constant.
2.2.2 Properties or Technical Attributes of the Consumption Function
The consumption function has two technical attributes or properties:
(i) the average propensity to consume (APC), and
(ii) the marginal propensity to consume (MPC).
2.2.2.1 Average Propensity to Consume
“The average propensity to consume may be defined as the ratio of consumption
expenditure to any particular level of income.” It is found by dividing consumption
expenditure by income, or APC = C/Y, where C = Consumption and Y = Income. It is
expressed as the percentage or proportion of income consumed.
Table 2.1 Average and Marginal Propensity to Consume
(Rs. Crores)
Income
(Y)
Consumption
(C)
APC
(C/Y)
APS
(1-APC)
MPC
(DC/DY)
MPS
(1-MPC)
200 200 200/200 = 1 0 - -
300 280 280/300 = 0.93 0.07 80/100 = 0.8 0.2
400 360 360/400 = 0.9 0.1 80/100 = 0.8 0.2
500 440 440/500 = 0.88 0.12 80/100 = 0.8 0.2
600 520 520/600 = 0.87 0.13 80/100 = 0.8 0.2
Source: Researcher’s own calculation.
Table 2.1 shows the APC at various income levels. The APC declines as income
increases because the proportion of income spent on consumption decreases. If
consumption expenditure is Rs. 200 and income is also Rs. 200, then APC = C/Y or
200/200 = 1, i.e. 100% of the income is spent on consumption.
But reverse is the case with average propensity to save (APS) which increases with
increase in income. Thus the APC also tells us about the APS, APS=1-APC.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
38
Diagrammatically, the average propensity to consume is C/Y, as shown in Figure 2.2.
Income is measured on X-axis and consumption is measured on Y-axis. CC is the
consumption curve. At point N on the consumption curve CC, APC = OM/OY1.
Figure 2.2 Measurement of Average Propensity to Consume
2.2.2.2 Marginal Propensity to Consume
“The marginal propensity to consume may be defined as the ratio of the change in
consumption to the change in income or as the rate of change in the average propensity
to consume as income changes.” It can be found by dividing change in consumption by
a change in income, or MPC = DC/DY, where D denotes change (increase or decrease),
C = Consumption and Y = Income.
Table 2.1 shows that the marginal propensity to consume (MPC) is constant at all levels
of income. It is 0.8 or 80% because the ratio of change in consumption to change in
income is DC/DY = 80/100. The marginal propensity to save (MPS) can be derived
from the MPC by the formula 1 - MPC. It is 0.2 in our example.
Diagrammatically, the marginal propensity to consume is measured by the slope of the
CС curve. This is shown in Figure 2.3. The marginal propensity to consume is
MP/Y1Y2, where MP is change in consumption (DC) and Y1Y2 is change in income
(DY).
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
39
Figure 2.3 Measurement of Marginal Propensity Consume
2.2.3 Keynes Psychological Law of Consumption
Keynes in his book “The General Theory of
Employment, Interest and Money,” 1936, postulated
that aggregate consumption is a function of aggregate
current disposable income. Keynes emphasized on
absolute size of income as a determinant of
consumption, his theory of consumption is also
known as absolute income theory. The relation
between consumption and income is based on his
fundamental psychological law of consumption which
states that when income increases, consumption
expenditure also increase but by a somewhat smaller amount. “The psychology of the
community is such that when aggregate real income is increased, aggregate
consumption is increased, but not by so much as income” (Keynes, 1936). Further
Keynes in his General Theory of Employment, Interest and Money (1936) remarked,
“The fundamental psychological law upon which we are entitled to depend with great
confidence both a prior from our knowledge of human nature and from the detailed
facts of experience, is that men are disposed, as a rule and on the average, to increase
their consumption as their income increases, but not by as much as the increase in their
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
40
incomes”. This law was popularly known as ‘Propensity to Consume’ and subsequent
writers called it ‘Consumption Function.’
2.2.3.1 Keynes’ Psychological Law of Consumption: Three Related
Propositions (Kennedy, 2011, p. 129)
Proposition 1:
“When the aggregate income increases, consumption expenditure also increases but by
a somewhat smaller amount. The cause is that as income increases, our wants have
already been satisfied side by side, so there is less need to increase consumption in
proportion to the increase in income. It means consumption expenditure will increase
by somewhat smaller amount with increase in income.”
This proportion shows, DC < DY.
Proposition 2:
“An increase in income is divided in some proportion between consumption
expenditure and saving. It means that income increases will either be consumed or
saved. This proposition follows the above proposition, as what is not spent on
consumption is saved.”
Proposition 3:
“With the increase in income both consumption spending and saving go up. This means
that increase in income is unlikely to lead either to fall in consumption or saving than
before it, therefore, emphasizes the short run stability of the consumption function.”
Figure 2.3 summarizes Keynes’ three propositions.
Figure 2.3 Summary of Keynes’ Three Propositions
Source: Researcher’s own Compilation.
•When income increases, consumption also increases but not in the same proportion.Proposition 1
•Increase in income will be divided in some proportion between consumption and saving.Proposition 2
•Increase in income leads to an increase in both consumption and savings.Proposition 3
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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Explanation with the help of schedule and diagram.
The three proposition of the law can be explained with the help of an example presented
in Table 2.2.
Table 2.2 Proposition of Keynes’ Law
(Rs. Crores)
Income
(Y)
Consumption
(C)
Savings
(S=Y-C)
0 40 -40
100 120 -20
200 200 0
300 280 20
400 360 40
500 440 60
600 520 80
Source: Researcher’s own calculation
Proposition 1:
Income increases by Rs. 100 crores and the increase in consumption is by Rs 80 crores.
The consumption expenditure increases from Rs. 280 to 360, 440 and 520 crores against
increase in income from Rs. 300 to 400, 500 and 600 crores. Hence, DC < DY.
Proposition 2:
The increased income of Rs 100 crores in each case is divided in some proportion
between consumption and saving (i.e. Rs 80 crores and Rs 20 crores).
Proposition 3:
As income increases from Rs. 200 to 300, 400, 500 and 600 consumption also increases
from Rs. 200 to 280, 360, 440, 520 crores, along with increase in saving from Rs. 0 to
20, 40, 60 and 80 crores respectively. With increase in income neither consumption nor
saving have fallen.
The three propositions are explained diagrammatically with the help of Figure 2.4.
Here, income is measured on X-axis and consumption and saving are on Y-axis. C is
the consumption function curve and 450 line where Y = C.
Proposition 1:
When income increases from OY1 to OY2 consumption also increases from BY1 to
C1Y2 but the increase in consumption is less than the increase in income, i.e., C1Y2 <
A1Y2 (= OY2) by A1C1.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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Figure 2.4 Keynes’ Three Propositions
Proposition 2:
When income increases to OY2 and OY3, it is divided in some proportion between
consumption C1Y2 and C2Y3 and saving A1C1 and A2C2 respectively.
Proposition 3:
Increase in income from OY2 to OY3 lead to increased consumption C2Y3 > C1Y2 and
increased saving A2C2 > A1C1 than before. It is clear from the widening area below the
C curve and the saving gap between 450 line and the C curve.
2.2.4 Keynes Conjectures
Keynes wrote in the 1930, at that time he didn’t have the advantage of the data nor the
computers necessary to analyses data sets. Keynes “discovered” this law not by
statistical analysis of data (there were no time series of national income and product
data at that time) but simply by casual observation and introspection. But today,
economists study is based on sophisticated techniques of data analysis. They analyses
aggregate data from the national income accounts and from surveys with the help of
computers and statistical software.
Following are the conjectures made by Keynes.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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Conjecture 1
Regarding the marginal propensity to consume (MPC), he conjectured that MPC is
between 0 and 1 (0 < MPC < 1), where MPC is “the additional amount of consumption
from additional amount of income.” If an individual’s income increases, then he will
spend a part of the incremental income and save some.
Conjecture 2
Keynes assumed that the average propensity to consume (APC), which is “the ratio of
consumption to income decreases with an increase in income.” He considered saving
as a luxury which could be afforded by the higher income groups. Thus he expected
APC to fall with rise in income.
Conjecture 3
Keynes considered income as the primary determinant of consumption, further he
thought that interest rate does not have a bearing on consumption. Knowing that higher
interest rates encourage savings and discourage consumption, he admitted that
theoretically interest rate could influence consumption. He noted that, “the main
conclusion suggested by experience, I think, is that the short-period influence of the
rate of interest on individual spending out of a given income is secondary and relatively
unimportant” (Keynes, 1936).
On the basis of above conjectures Keynes consumption function is written as:
C = a + bY, a > 0, 0 < b < 1
Where C is the consumption expenditure, Y is the disposable income, ‘a’ is the intercept
term, a constant which measures consumption at a zero level of disposal income. Thus
‘a’ is autonomous consumption. The parameter ‘b’ is the marginal propensity to
consume (MPC), which measure the increase in consumption spending in response to
per unit increase in disposable income.
Graphically this consumption function can be represented as a straight line, as shown
in Figure 2.5.
Conjecture 1
Keynes’s first conjecture that marginal propensity to consume is between 0 and 1 is
satisfied by the above graph. Thus with a rise in income, consumption and savings both
will increase.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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Figure 2.5 Keynes Consumption Function
Conjecture 2
The said figure satisfies Keynes’s second conjecture, the average propensity to
consume falls with the rise in income. As shown in the graph,
APC = C/Y = a/Y + b (C = a + bY).
As income rises a/Y falls leading to a fall in the APC.
Conjecture 3
And finally, this consumption function satisfies Keynes’s third conjecture because
Keynes identifies income as the only determinant of consumption and disregards
interest rate as the determinant.
2.2.5 Assumptions of Keynes Consumption Function
Keynes's Law is based on the following assumptions (Chaturvedi and Mittal, 2013, p.
37).
2.2.5.1. Stable Psychological and Institutional Factors
This law assumes that the psychological and institutional factors like social customs,
population growth, tastes, price movements, habit, etc. influencing consumption
expenditure remain constant. These factors do not change in the short run and income
is the only determinant of consumption. The fundamental cause of the stable
consumption function is the constancy of these factors.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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2.2.5.2. Normal Conditions
The law holds well under normal conditions but under abnormal and extraordinary
circumstances like hyperinflation, war or revolution, the law will not operate. People
may spend the whole of increased income on consumption.
2.2.5.3. Laissez Faire Economy
The French term 'Laissez Faire' means 'leave alone'. The term refers to an economic
system where the transactions among private parties are free of government
intervention. The government invention could be the form of licensing, subsidies or
tariffs. The idea was that in free market capitalism the less the government intervention
the better it would be for businesses and put collectively the society as a whole would
be better off. As a law, it's essentially operative only in capitalist economies and breaks
down in socialist or regulated economies.
Summary of the assumption is captured in Figure 2.6.
Figure 2.6 Summary of the Assumptions of Keynes Consumption Function
Source: Researcher’s own Compilation
Professor Kurihara opines that “Keynes’s law based on these assumptions may be
regarded as a rough approximation to the actual macro-behaviour of free consumers in
the normal short period” (as cited in Jain and Khanna, 2007, p. 126).
2.2.6 Implication of Psychological Law of Consumption or Importance
of Keynes’s Law
According to Prof. A.H. Hansen (1946, p. 183), “Consumption function is an epoch
making contribution to the tools of economic analysis, analogous to, but even more
important than, Marshall’s discovery of the demand function”. Keynes's psychological
•Social customs, tastes, consumption habits, price movement, population growth, etc. remains constant.
Stable Psychological and Insitutional Factors
•Law will not operate in situations like war, revolution, depression, hyper inflation, etc.Normal Condition
•Law operates where there is no government interference. Laissez Faire Economy
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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law underscores the importance of the consumption function since the latter is, based
on the former. It has immensely important – both theoretically and practically. All
countries, work towards removing unemployment, raising national income and
enjoying prosperity. A well planned economic development policy is essential to meet
this purpose. In formulation of this policy, consumption function plays a very important
role (Jain and Khanna, 2007, p. 128).
2.2.6.1 Say’s Law of Market
Say’s law of markets which is the fundamental basis of classical theory of income and
employment, states that “Supply creates its own demand”. Hence, there is no scenario
of unemployment and over production. Consumption function establishes that the
increase in additional income does not fully result into increase in consumption goods.
Hence, according to Keynes, “supply does not create its own demand.” Instead, it very
often exceeds it and creates a surplus of goods which causes over production and mass
unemployment.
2.2.6.2 Role of Investment in Employment Theory
According to Keynes, employment level can be increased by raising consumption and
investment. But consumption function in the short term remains almost constant and
hence may be assumed as given. Thus, investment is the vital factor in determining the
employment level.
2.2.6.3 Turning Points of the Business Cycle
During the economic boom period, despite an increase in income, consumption
expenditure does not increase in the same proportion. Hence, there is a rise in savings
and decline in demand which correspondingly leads to a period of economic downturn.
Similarly, during the period of slump, while there is a decline in income, expenditure
on consumption does not decline to the full extent of the fall in incomes. This leads to
period of economic boom.
2.2.6.4 Tendency of Marginal Efficiency of Capital
In rich advanced countries, the Marginal Propensity to Consume (MPC) is < 1. Hence,
Marginal Efficiency of Capital (MEC) shows a downward trend. This is because as
income increases, expenditure declines, savings increase, demand drops, production
declines, profits fall – ultimately resulting in a decline in MEC. Hence, economic
growth declines with a decline in investment.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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2.2.6.5 Secular Stagnation
Typically, the MPC is low and Marginal Propensity to Save (MPS) is high in most of
the developed nations. The gap between income and consumption continues to increase
compelling an increase in investment. Similar to the propensity to consume, propensity
to save also tends to be stable and reduces over time. Thus, the economy will come to
a stage where it will be unable to fully and effectively use its savings for promoting full
employment. Keynes refers to this as “Secular Stagnation”.
2.2.6.8 Value of Multiplier
Multiplier’s value is derived from consumption function. K = 1/1-MPC or 1/MPS. This
helps us understand the multiplier effect. Since the MPC is less than 1, the increase in
national income is not directly equal to the investment. The multiplier effect declines
when consumption expenditure drops in an economy.
2.2.6.9 Under-Employment Equilibrium.
Since MPC is less than unity, the consumers do not spend the full increase in income
on consumption. Effective demand becomes insufficient to lead to a full employment
equilibrium. Thus, the economy remains at under employment.
2.2.6.10 State Intervention.
The economy is not self-adjusting to the situations that arises from lack of consumption
like over production and unemployment. Hence, government intervention becomes
indispensable. Thus, consumption function helps us to analyse the income generation
process, growth in employment levels, need for the government involvement and a very
high level of investment to maintain national income and employment.
2.2.7 Determinants of Consumption Function
Keynes refers two primary factors which influence the consumption function and define
its slope and position. These are subjective and objective factors. The subjective factors
are internal or endogenous to the economic system, they include psychological features
of the human nature, social arrangements and social practices and institutions. They
“are unlikely to undergo a material change over a short period of time except in
abnormal or revolutionary circumstances.” They therefore, determine the slope and
position of the С curve which is almost stable in the short-run (Keynes, 1936).
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
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The objective factors are external or exogenous to the economic system. These factors
may experience swift changes and may cause noticeable shifts in the consumption
function (i.e., the С curve).
2.2.7.1. Subjective Factors
The subjective factors can further be studied under Individual and Business motives.
2.2.7.1.1 Individual Motives:
There are eight motives “which refrain individuals from spending out of their incomes.”
They are:
(i) The desire to accumulate funds for unexpected contingencies;
(ii) The desire to make provisions for expected future needs, i.e., old age, sickness, etc.;
(iii) The desire to enjoy a large future income through interest and appreciation;
(iv) The desire to improve the standard of living by gradually increasing expenditure;
(v) The desire to enjoy a sense of independence and power to do things;
(vi) The desire to secure a “masse de manoeuver” to undertake speculative or business
projects;
(vii) The desire to pass on a fortune; and
(viii) The desire to fulfil a pure miserly instinct.
2.2.7.1.2 Business Motives:
Keynes lists four motives for accretion on their part:
(i) Enterprise – the desire to expand business and do big things;
(ii) Liquidity – the desire to meet contingencies and problems;
(iii) Income raise/Bonus – the desire to accumulate large income and highlight the
efficiency and effectiveness of the management;
(iv) Financial prudence – the desire to provide sufficient financial resources to offset
depreciation and obsolescence, and to repay debt;
These factors see less variations and are fairly constant during the short-term, which in
turn keeps the consumption function stable.
In the words of Keynes (1936), “Those psychological characteristics of human nature
and those social practices and institutions which, though not unalterable, are unlikely
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
49
to undergo a material change over a short period of time except in abnormal or
revolutionary circumstances.”
2.2.7.2. Objective Factors
Objective factors are subject to quick changes and lead to significant shifts in the
consumption function, they are as below:
2.2.7.2.1. Windfall Gains or Losses
Consumption level of people may change suddenly when they realize windfall gains or
losses. For example, the post-war windfall gains in stock markets seem to have raised
the consumption spending of rich people in the U.S.A., and correspondingly, the
consumption function shifted upwards.
2.2.7.2.2. Fiscal Policy
The propensity to consume is also impacted by changes in fiscal policy of the
government. For instance, levy of heavy taxes tends to lower the disposable real income
of people; so consumption level may adversely change. Conversely, withdrawal of
certain taxes may lead to an upward shift of consumption function.
2.2.7.2.3. Change in Expectations
The propensity to consume is also impacted by prospective changes. For example, an
anticipated war substantially influences consumption by building fears regarding future
scarcity and rising prices. This leads to hoarding as people buy more than they
immediately need. Thus, the ratio of consumption to current income will increase,
implying that the consumption function will be shifted upwards.
2.2.7.2.4. The Rate of Interest
In the long term, considerable changes in the market rate of interest may also impact
consumption. A significant increase in the rate of interest may encourage people to take
advantage of the higher interest rate and save more, thereby reducing the consumption
at each income level. Moreover, if the interest rate increases, then the lending of the
current savings (realised from lower consumption) will allow one to obtain an even
greater quantity of consumption goods in the future. Keynes, thus, argues that “Over a
long period, substantial changes in the rate of interest probably tend to modify social
habits considerably.”
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In addition to above factors, Keynes also referred to changes in wage levels, in
accounting practices with respect to depreciation (indicating the difference between
income and net income), as the objective factors affecting the consumption function.
Keynes’ followers, however considered his set of objective factors as inadequate
and included additional factors as mentioned below:
1. The Distribution of Income
With a given level of income, total consumption will vary if income is distributed
differently among the people. A community with a high unequal distribution of income
is likely to have an overall low propensity to consume, while a high degree of equality
of income will generally have a high propensity to consume.
Thus, propensity to consume is affected by the redistribution of income through fiscal
measures of the State. Joan Robinson explicitly states that “the most important
influence on the demand for consumption goods is the distribution of income.” Keynes
does not call out income distribution as an objective factor, rather includes it under the
common heading of fiscal policy.
2. Holding of Saving-Liquid Assets
According to Kurihara, “Volume of total savings is another factor affecting the
consumption function” (as cited in Jain and Khanna, 2007). Greater the savings (i.e.,
liquid assets, like cash balances, savings accounts and government bonds), the more
likely that people will likely spend out of their current income, since the holding of
savings in the form of liquid assets, will provide them with a greater sense of security.
A change in the real value of these liquid assets, due to changes in market prices, might
also impact the consumption function.
3. Corporate Financial Policies
Kurihara points out that that business policies of companies in relation with income
retention, dividend payments, and re-investments, lead to some changes in the
propensity to consume of equity shareholders. A conservative dividend policy followed
by companies will lower the consumption function by reducing the residual disposable
income of shareholders (who are the actual consumers).
All the aforementioned factors will affect the consumption function positively or
negatively. However, all of them are relatively stable in the normal short term and,
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
51
therefore, cannot explain the changes in aggregate consumption in the short term.
Income is the only variable which will change noticeably in the short term and affect
consumption. Thus, it may be asserted that consumption varies only with the changes
in income levels.
2.2.8 Empirical Study of Consumption Function
2.2.8.1 The Early Empirical Successes
Shortly after Keynes proposed the consumption function and its conjectures,
economists and statisticians took up the task of empirically verifying its propositions.
They conducted primary research whereby they surveyed, collected, interpreted and
analyse data collected from households. As part of their research they focused on
consumption, savings and income patterns and propensities.
The findings of these research were as follows:
1. Household units with higher income consumed more, confirming that MPC > 0.
2. Household units with higher income saved more, confirming that MPC < 1.
3. Household units with higher income saved larger proportion of their income,
confirming that APC falls with rise in income.
4. Very strong correlation between income and consumption and income seemed to be
the main determinant of consumption.
Thus Keynes’s proposition met with initial empirical success.
2.2.8.2 Empirical Contradictions
Although the Keynesian consumption function was empirically confirmed by initial
studies, but it was soon confronted with anomalies. These anomalies are concerned with
the Keynes’s conjecture that the average propensity to consume falls as income rises.
The first exception was noticed during World War II, when some economists, based on
Keynesian consumption function feared that consumption would grow more slowly
than income over time resulting in decline in the average propensity to consume. Higher
savings rates (lower APC) could mean a lack of aggregate demand and a return to the
depression-like conditions before the war. In other words, these economists envisaged
that the economy would experience what they called secular stagnation - a long
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
52
depression of indefinite duration. To overcome from this situation government needed
to make up the spending deficit with fiscal expansions.
Providentially, this prediction did not come true. After the war, as incomes grew,
average propensity to consume did not fall and consumption grew at the same rate as
income, means savings rates did not rise as incomes rose. So, Keynes’s conjecture that
average propensity to consume would fall as income increases did not hold. This was
in favour of the economy, but against the Keynesian consumption function.
2.2.8.3 The Consumption Puzzle – Simon Kuznets
Noted American economist Simon Kuznets
conducted empirical studies regarding consumption
of the US economy for the period 1869-1938. His
study was based on a cross-section of household
budget data over long term time-series data. The study
revealed that while the findings of Keynes’
consumption function were correct over the short
term, in the long term there were contradictions.
These contradictions in the economic circles are often
referred to as the “Consumption Function Puzzle.”
Several economists attempted to resolve this puzzle and in process also put forward
new theories to explain the puzzle.
Kuznets’ Consumption Function
As seen, Keynes represented the consumption function as ‘C = a + bY’, stating that
even at zero income level there will be certain consumption financed by dissavings or
borrowings. Thus the average propensity to consume would also reduce as income rose.
On the other hand, Kuznets found that consumption function is of the following form,
‘C = bY’, where C = consumption, b = marginal propensity to consume and Y = Income
Note that in Kuznets’ consumption function there exists no autonomous consumption
or intercept term. As shown in Figure 2.7 Kuznets’ consumption function curve begins
from the origin and is quite close to 45° line depicting high propensity to consume (b).
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
53
For the period 1869-1933 Kuznets with his empirical study estimated that the average
propensity to consume was nearly 0.9 (Alimi, 2013, p. 4). Further, by dividing the entire
period (1869-1933) into three overlapping thirty years sub-periods Kuznets found that
average propensity to consume was almost the same at about 0.87 in all the three sub
periods.
Thus Kuznets concluded that there was no tendency for the average propensity to
consume to decline as disposable income rises. Therefore, rounding off Kuznets
findings the estimated propensity to consume is 0.9. His consumption function can be
rewritten as C = 0.9Y.
Figure 2.7 Kuznets’ Consumption Function
Consumption function of Keynes (C = a + bY) and Kuznets (C = bY) are different in
two aspects. Firstly, as per Keynes’ consumption function APC falls as income rises
whereas in Kuznets ‘consumption function APC remains constant over a long period.
Further, the marginal propensity to consume (MPC), is significantly higher in Kuznets’
function when compared to that of Keynes.
In reconciliation of the two consumption functions economists have observed that while
Keynes’ function is a short run consumption function, ‘Kuznets’ function is concerned
with long run and thus has been referred to as long run consumption function.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
54
2.3 RECONCILIATION OF SHORT PERIOD AND LONG
PERIOD CONSUMPTION FUNCTION
Different hypotheses have been developed by economists in order to explain the
contradiction between the short run non-proportional and the long run proportional
consumption-income relationship. The first attempts to reconcile the short run and long
run consumption functions was made by Arthur Smithies and James Tobin followed by
James S. Duesenberry in 1949, known as ‘Relative Income Hypothesis.’ Later on
Franco Modigliani presented Life Cycle Hypothesis and Milton Friedman the
Permanent Income Hypothesis in the 1950s, they also tried to solve the consumption
puzzle and find out the explanations of these contradictory findings.
2.3.1 Drift Theory of Consumption
On the first noteworthy
attempts to reconcile
the short run and long
run consumption
functions was made by
Arthur Smithies and
James Tobin. In
separate studies they
tested Keynes absolute
income hypothesis and
arrived at the conclusion that in the short run there exists a non-proportional relationship
between consumption and income but the time series data showed that over long run
the relationship is proportional.
According to Smithies and Tobin, in long run the consumption income shift results in
a proportional relationship because of factors other than income. They identified the
following factors that bring about the shift.
2.3.1.1 Asset Holdings
Tobin studied asset holdings as part of the household budgets across the racial divide
(he assumed that the most of the so called whites held assets as against the African
Smithies Tobin
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
55
migrants). He concluded that asset holdings of households was one of that factors that
tends to cause an upward shift in the consumption function i.e. leads to higher
propensity to consume.
2.3.1.2 New Products
Introduction of new products lead to an upward shift in consumption function. This
finding was a result of studying a variety of consumer goods that were introduced post
the Second World War.
2.3.1.3 Urbanization
Another reason for higher propensity to consume was the Urbanization. Wage earners
in urban areas had a higher propensity to consume versus the farm workers in rural
areas. After the Second World War an increased tendency was seen toward urbanization
which also shifted the consumption function upwards.
2.3.1.4 Age Distribution
One of findings was that over long run there has been a continuous increase in the
proportion of old people in the total population. While the old people may not be
earning they do consume commodities. Therefore, an increase in their numbers has
influenced to shift the consumption function upward.
2.3.1.5 Decline in Saving Motive
Development of the social security program allows households to set aside smaller
portions of income for illness and old age. This leads to higher funds for consumption
and shifts the consumption function upwards.
2.3.1.6 Consumer Credit
Easy availability of credit ensures that consumers do not have to save or earn first and
spend later, rather they can make purchases now with payments on instalment basis,
and this brings about an upward shift in the consumption function.
2.3.1.7 Expectation of Increase in Income
Workers expecting their wages to increase at a rate higher than the rate of inflation tend
to factor in the expected higher incomes and consume accordingly. They consume
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
56
higher amounts in the present by either saving less or by drawing upon their existing
savings or by availing short term credit. This leads to higher propensity to consume.
Figure 2.8 Drift Theory of Consumption
In the Figure 2.8, L1 depicts the long run consumption function, given the 45 degree
angle it demonstrates the proportional relationship between income and consumption.
S1 and S2 represent the short run consumption functions, which intersect the long run
function at points N and M respectively. On account of factor elaborated above the
consumption function drift upward from point M to N along the long run consumption
function of L1.
Each point on the long run consumption function represents an average of all the values
of factors included in the corresponding short run functions however movement along
the dotted line of S1 and S2 would not increase in proportion.
Shortcomings of Drift Theory of Consumption
The Drift theory of consumption holds merit for the fact that it introduces a new
dimension of factors affecting consumption in addition to the income. This is significant
departure from the other theories. However it has its share of shortcomings.
Firstly, the theory is silent on the rate of drift along the long run consumption function,
most of which appear to be matter of chance.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
57
Secondly, it is just happenstance that the other factors have the consumption function
move upward to increase the propensity to consume proportionately with increase in
income, such that short run averages equals a fixed proportion of income.
Thirdly, according to Duesenberry the factors mentioned are not strong enough to cause
a drift.
Lastly, Duesenberry adds that any increase in propensity to consume would mean fall
in the propensity to save. Given that individuals would like to save for their post
retirement needs there may not be necessarily a secular trend of increase propensity to
consume and proportional relationship of income and consumption.
2.3.2 The Relative Income Hypothesis
In 1949, American Economist James Duesenberry in
his publication titled "Income, Saving, and the Theory
of Consumer Behaviour" put forward the "relative
income theory of consumption", also referred as
"Relative Income Hypothesis".
Drift theory lay stress on factors other than income
which affect the consumer behavior and represents a
major advance theory of the consumption function.
While relative income hypothesis by using the income
and consumption data of 1940s argued that
consumption function is long run and proportional in nature. It means that in short run
there can be deviations in income and consumption behaviour but in long run
consumption to income proportion is fairly stable. The hypothesis is based on below
two assumptions:
1) Individuals consumption behaviour pattern is interdependent on societies/other
individual consumption pattern. Explained through "Demonstration Effect".
2) Consumption relations are irreversible. Explained through "Ratchet Effect".
Duesenberry states that "for any given relative income distribution, the percentage of
income saved by a family will tend to be a unique, invariant, and increasing function of
its percentile position in the income distribution. The percentage saved will be
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
58
independent of the absolute level of income. It follows that the aggregate saving ratio
will be independent of the absolute level of income" (Duesenberry, 1949, pg. 3).
2.3.2.1 Demonstration Effect
It states that the percentage of income consumed by an individual is dependent on the
level of consumption expenditure made by the individuals with which it identifies itself.
It means, consumption pattern of individuals is determined by the consumption pattern
of society in which she/he thinks they represents.
Duesenberry (1949, p. 19) states “A real understanding of the problem of consumer
behaviour must begin with a full recognition of the social character of consumption
patterns”. By the “social character of consumption patterns” he means the tendency in
human beings not only “to keep up with the Joneses” but also to surpass them.
Joneses refers rich people and individuals constantly tend to move towards higher
consumption level and to imitate consumptions of rich individuals in the society. Thus
individual’s consumptions patters are interdependent and differences in relative
incomes of individuals drive consumption expenditures. Due to it rich people require
have lower average expenditure (Consumption upon Income or c/y) i.e. lower average
propensity of consumption (APC) or on the other hand individuals with lower incomes
will have higher APC while trying to “to keep up with the Joneses" which can also lead
to negative savings. It provides explanation for stable long run - consumption or APC
as lower and higher APCs would balance out while aggregating. Even if the absolute
size of income in a country increases, the APC for the economy as a whole at the higher
absolute level of income would be constant. But when income decreases, consumption
does not fall in the same proportion because of the Ratchet Effect.
2.3.2.2 Ratchet Effect
It is the result of individual’s refusal to reduce consumption with a fall in income. It
means when absolute income increases, absolute consumption increases but when
absolute income decreases the proportionate reduction in consumption is less than fall
in income, as in the long run individuals are accustomed to a certain standard and
manner of living. This results in increasing APC for individuals and reducing MPC.
Duesenberry (1949, p. 115) states “the ratchet keeps the economy from slipping back
all the way and losing all the gains in income acquired during the preceding boom”. It
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
59
is also referred as “past peak of income” hypothesis which explains the short run
fluctuations in the consumption function and refutes the Keynesian assumption that
consumption relations are reversible.
James Duesenberry's Consumption Function
(Ct/Yt) = a – c (Yt/Yo)
where, C = Consumption, Y = Income, t = Current Period, o = Peak Period, a = Constant
relating to positive autonomous consumption and c = Consumption function.
In the equation the ratio of current consumption to income (Ct/Yt) equates to function
of Yt/Yo, that is, the ratio of current income to the previous peak income. If the ratio
is constant as in periods of steady income increase, the current consumption income
ratio is constant. During the period of recessions when current income (Yt) falls below
the previous peak income (Yo), the current consumption income ratio (Ct/Yt) will
increase.
Diagrammatical representation of relative income hypothesis.
Figure 2.9 represents relative income hypothesis where L1 is the long-run consumption
function and S1 and S2 are the consumption functions for the short run. Suppose income
is at the peak level of OY2 where M2Y2 is consumption. Now income falls to OY1.
Since people are used to the standard of living at the OY2 level of income, they will not
reduce their consumption to M1Y1 level, but reduce it as little as possible by reducing
their current saving. Thus they move backward along the S1 curve to point N1 and be at
N1Y1 level of consumption. When the period of recovery starts, income rises to the
previous peak level of OY2. But consumption increases slowly from N1 to M2 along the
S1 curve because consumers will just restore their previous level of savings. If income
continues to increase to OY3 level, consumers will move upward along the L1 curve
from M2 to M3 on the new short-run consumption function S2.
If another recession occurs at OY3 level of income, consumption will decline along the
S2 consumption function toward N2 point and income will be reduced to OY2 level. But
during recovery over the long-run, consumption will rise along the steeper L1 path till
it reaches the short run consumption function S2. This is because when income increases
beyond its present level OY2, the average propensity to consume becomes constant over
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
60
the long-run. The short-run consumption function shifts upward from S1 to S2 but
consumers move along the L1 curve from M2 to M3. But when income falls, consumers
move backward from M3 to N2 on the S2 curve. These upward and downward
movements from N1 and N2 points along the L1 curve give the appearance of a ratchet.
This is the ratchet effect. Thus the ratchet effect shows that, “the short run consumption
function ratchets upward when income increases in the long run but it does not shift
down to the earlier level when income declines. Thus the ratchet effect will develop
whenever there is a cyclical decline or recovery in income.”
Figure 2.9 Relative Income Hypothesis
2.3.2.3 Shortcomings of Relative Income Hypothesis
1). Consumption patterns are not irreversible i.e. empirical evidence shows that in long
run they are reversible and in short run they are irreversible.
2). No proportional increase in consumption as increases in income along the full
employment level do not always lead to proportional increases in the consumption.
3). No direct relationship between consumption and income as recessions does not
always lead to decline in consumption as it was case in 1948-49 and 1974-75.
4). Theory neglects important economic factors like age of population, urbanization,
investment and asset holdings of individuals which play a very important role in
individuals consumption decisions.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
61
5). Consumer preferences are independent as empirical study by George Katona’s
revealed that expectations and attitudes play an important role in consumer spending.
6). According to him, income expectations based on levels of aspirations and the
attitudes toward asset holdings affect consumer spending behaviour more than the
demonstration effect.
2.3.3 Modigliani’s Life Cycle Hypothesis and Friedman’s Permanent
Income Hypothesis
Before proceeding towards the work done by these two economists, we must discuss
Irving Fisher’s contribution to consumption theory. As both Modigliani’s life-cycle
hypothesis and Friedman’s permanent-income hypothesis are based on the theory of
consumer behaviour proposed by Irving Fisher (Mankiw, 2010).
2.3.3.1 Irving Fisher and Intertemporal Choice
The noted economist Irving Fisher proposed the
theory of intertemporal choice in his book “Theory of
Interest” (1930). His model demonstrates how
rational consumers would allocate their consumption
across time. The intertemporal approach is the basis
of theories that would clarify “why the average
propensity to consume (APC) behaved differently in
varied sets of data.”
The consumption function presented by Keynes
relates “current consumption to current income.” It discounts the fact that consumption
has intertemporal aspects, for e.g. a decision to eat a cookie today, is a decision not to
eat cookie tomorrow. Contrary to Keynes, “Fisher’s model displays how rational
forward looking consumers choose consumption for the present and the future to
maximize their lifetime fulfilment or make intertemporal choices – that is choices
relating to different time periods.”
Fisher’s model of intertemporal choice explains:
· The constraints that consumers face,
· The preferences they have, and
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
62
· How consumers make decision around consumption and saving given the
constraints and preferences.
2.3.3.1.1 The Intertemporal Budget Constraint
Everyone aspires to have a luxurious life – i.e. to increase our consumption, we want
to live in bigger homes, to own luxurious cars, to go on exotic holidays, but why does
one consume less than what we desire? Because the consumption is constrained by
income. In other words, consumers are limited in how much they can spend, also called
as budget constraint. When consumers have to choose between how much to consume
today vs. the future, they face an intertemporal budget constraint, “which measures the
total resources available for consumption today and in the future.”
2.3.3.1.2 Model: Two Period
Suppose that a household consumer lives across two time periods: young and old
corresponding to her/his working years and her/his retirement years respectively.
She/he has an income Y1 and consumption C1 when she/he works, and Y2 and C2 when
she/he is old (All variables are real – that is, adjusted for inflation). She/he can save and
borrow in each period with the same real interest rate r.
Consider how the consumer’s income in the two periods constraints her/his
consumption.
In period 1: Savings in the first period (which can be positive or negative)
S = Y1 – C1 (2.1)
where S is saving.
Consumption in the second period equals the total savings, including the interest earned
on that saving, plus second-period income. That is,
C2 = (1+r) S + Y2 (2.2)
where r is the real interest rate. For example, if the real interest rate is 10% and the
saving of the consumer is Rs. 10/- in period one then the consumer will enjoy Rs. 1.00/-
extra consumption in the second period, since there is no third period, hence the
consumer does not save in the second period.
Note: Variable S can represent either saving or borrowing. (If C1< Y1, then saving and
S > 0 and if C1> Y1, then borrowing and S < 0)
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
63
Combining (2.1) and (2.2) equations gives:
C2 = (1+r) [Y1 – C1] + Y2
Rearranging the equation by taking consumption terms together (1+r) C1 from the right
hand side to the left hand side of the equation, we get
(1+r) C1 + C2 = (1+r) Y1 + Y2
Now dividing both sides by (1+r) gives:
�� +��
(� + �)= !� +
!�
(� + �)
This equation shows the relationship between consumption in the two periods to the
income in the two periods.
2.3.3.1.3 Special Case
If the interest rate is equal to zero or r = 0, then we have
C1 + C2 = Y1 + Y2
When rate of interest is greater than zero or r > 0, then future consumption (C2) and
future income (Y2) are discounted by a factor 1+r.
Usually interest rates are positive and thus both the future consumption and income are
discounted by the factor 1+r. A consumer may be accumulate savings (when C1< Y1)
or non-savings (when C1>Y1) in the first period. The savings made in the first period
by a consumer would help him earn interest at the r% rate and contribute to additional
income of S (1+r) for the second period.
For a consumer who has incurred non-savings in the first period suggests that she/he
borrowed money for additional consumption, hence she/he will have to pay interest at
the r% rate on the borrowed amount and thus her/his income for the second period
would be lowered by a –S(1+r). For every 1 unit of additional consumption in the
second period consumer would need to save 1/(1+r) in the first period. By discounting,
we put things in terms of present values.
�� +��
(�"�) = !� +
!�
(�"�)
(Present Value of Consumption) (Present Value of Income)
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
64
2.3.3.1.4 Consumer’s Budget Constraint: Graphical Presentation
Figure 2.10 presents the combinations of 1st period and 2nd period consumption that the
consumer can choose. If she/he chooses the point N, then there is neither saving nor
borrowing between two periods and she/he consumes all her/his income in two periods.
Hence, C1 = Y1 and C2 = Y2.
Figure 2.10 Intertemporal Budget Line
At point M, C1 = 0, it means consumer consumes nothing in the first period and saves
all income, so,
C2 (Second period consumption) = (1+r) Y1 + Y2
At point P, C2 = 0, which implies that consumer plans to consume nothing in the second
period.
If she/he chooses points between N and M, then the consumer is not consuming her/his
entire income in the first period and is saving for the second period.
If she/he chooses points between N and P, then the consumer is consuming more than
her/his income in the first period and is hence borrowing from her/his second period
i.e., consumes less than her/his income in period first (C1 < Y1) and saves for the second
period.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
65
2.3.3.1.5 Consumer Preferences
Time indifference curves can be drawn to represent the consumer’s preference in the
two time periods: period 1 and period 2. Indifference curves have the following
characteristics:
· An indifference curve gives alternative combinations of consumption (C1 and
C2) in the two periods that gives the consumer the same level of satisfaction.
· A consumer is indifferent to the various combinations on the indifference curve
as they are on the same curve
· The slope of the indifference curve denotes how much of the consumption in
the second period does the consumer require in order to be compensated for one
unit reduction in the first period consumption. The slope is called the Marginal
Rate of Substitution (MRS).
· A group of indifference curves is called an indifference map. On an indifference
map, higher the indifference curve, higher is the satisfaction. Thus consumers
prefer higher indifference curves.
Figure 2.11 shows two indifference curves IC1 and IC2. All the combinations on IC1
i.e., A, B and C provide the same level of satisfaction, because they are all on the
same curve and consumer is indifferent between those combinations.
Figure 2.11 The Consumer’s Preference
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
66
Since the indifference curves are not straight lines the Marginal Rate of Substitution
(MRS) depends on the consumption level in the two periods. At point C on IC1, when
the first period consumption is high and second period is low, thus the MRS is low
since only a small amount of second period consumptions is to be given up for an
additional unit of consumption in first period. Likewise, the MRS is high at point A on
IC1.
In the indifference map having IC1 and IC2 as shown in Figure 2.11, the consumer will
prefer IC2, because she/he would prefer more consumption to less, and hence would
prefer a higher indifference curve vs. the lower ones. The consumer is indifferent
among points A, B and C, but prefers point D, as it is on higher indifference curve (IC2).
2.3.3.2 The Life Cycle Hypothesis
Franco Modigliani and Albert Ando in 1950's put forth
life cycle theory of consumption which is also referred
to as “Life Cycle Hypothesis.” It states that “an
individual’s consumption in any period is not the
function of current income of that period, but of the
whole lifetime expected income.”
The consumption depends on the resources available,
the rate of return on capital, the spending plan, and the
age of individuals i.e. the total resources consist of his
income and wealth.
The hypothesis is based on below assumptions:
1). No change in the price level during the life of the consumer.
2). The consumer’s assets are a result of his/her own savings and are not a result of
inheritance.
3). The rate of interest paid on assets is zero.
4). Current savings result in future consumption.
5). She/he intends to consume her/his total lifetime earnings plus current assets.
6). No plans for any bequests.
7). Certainty about her/his present and future flow of income.
8). Individual has a definite vision of life expectancy.
Modigliani
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
67
9). Individuals are aware of the future emergencies, opportunities and social pressures
that will come upon her/his consumption spending.
10). Rational Consumer.
The theory emphasizes that income changes in each period and saving help households
to carry out a part of their income from period where income is high to periods where
it is low and by accumulating and then dispensing assets, people provision for their
retirement and align their consumption patterns to their needs at different life stages as
depicted in Figure 2.12.
Figure 2.12 Consumption, Income and Wealth over the Life Cycle
Source: Researcher’s own Compilation
To summarize consumption is a function of lifetime expected income of the consumer
which depends on her/his resources. In some resources, her/his current income, present
value of her/his future expected labour income and present value of assets are included.
Life Cycle Consumption Function
C × (NL - T) = WR + (WL – T) × YL
Where C = Annual Consumption, WR = Current wealth, (WL – T) = Remaining
working life, YL = Expected income accrual for another (WL- T) years and (NL - T) =
Remaining assumed life.
To have smoothest consumption over lifetime, consumer divides such that:
C = aWR + cYL
where a = 1/ (NL - T) and c = (WL – T)/(NL - T)
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
68
In other words, a = MPC out of Wealth, and c = MPC out of Income
Figure 2.13 Life Cycle Consumption Function
The function considers consumption of both income and wealth over an individual’s
lifetime. In other words, the intercept of the Figure 2.13 of the consumption function
depends on current wealth.
2.3.3.2.1 Implication of Life Cycle Hypothesis
1). It help solves the consumption puzzle that the short-run consumption function would
be non-proportional as in the short-run time series estimates.
2). Savings change along the consumer’s lifecycle, adulthood begins with no wealth
and the consumer accumulates wealth through savings over the working life. But during
retirement, she/he will dissave and run down her/his wealth.
3). The life cycle hypothesis also implies that a high-income family consumes a smaller
proportion of her/his income than a low-income family where the consumption is high.
2.3.3.2.2 Shortcomings of Life Cycle Hypothesis
1). Lifetime consumption is unrealistic as individuals focuses more on current
consumption than future consumption.
2). Consumption is not directly related to assets of individuals. It assumes, as assets
increases consumption also increases. It also does not consider that individual might
reduce consumption to increase assets.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
69
3). Consumption depends on attitude and behaviour towards life rather than income and
assets.
4). Individuals are not always rational and knowledgeable and they tend to behave
irrationally to different situations.
5). Estimating future income is not possible as it may change depending on future
circumstances.
6). It fails to account for liquidity constraints that may arise in future for an individual
due to unusual circumstances.
7). It does not consider rate of growth and locked up savings in consumption.
2.3.3.3 The Permanent Income Hypothesis
In 1957, American economist Milton Friedman in his
famous work entitled "A Theory of the Consumption
Function” presented the permanent-income
hypothesis to explain consumer behaviour.
Both relative income and life cycle hypothesis base
consumption to current relative income and current
absolute income. Friedman rejected both these current
income hypothesis and stated that consumption is
determined by long-term expected income rather than
current level of income. This long term expected
income is referred by Friedman as permanent income and the hypothesis is popularly
referred as "Permanent Income Hypothesis". Friedman States "an individual who is
paid or receives income only once a week, say on Friday, he would not concentrate his
consumption on one day with zero consumption on all other days of the week." It means
"that an individual would prefer a smooth consumption flow per day rather than plenty
of consumption today and little consumption tomorrow."
Permanent income is earned from both “human and non-human wealth."
1). Human Wealth is wealth from human capital including training, education, skill
and intelligence.
2). Non-Human Wealth or Capital is wealth from assets as money, stocks, bonds,
and real estate and consumer durables.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
70
Friedman states “individual’s current income (Y) as the sum of two components,
permanent income (Yp) and transitory income (Yt).” Transitory income is the part
of income that people do not expect to persist.
Y = Yp + Yt
The hypothesis is based on below assumptions:
1). No correlation between transitory income and permanent income.
2). No correlation between permanent income and transitory consumption.
3). No correlation between transitory consumption and transitory income.
4). Only permanent income changes affects consumption.
5). Individual estimates permanent income through backward looking of expectations.
According to permanent income hypothesis, “consumption is proportional to permanent
income. Consumption should depend primarily on permanent income because
consumers use savings and borrowings to smooth consumption in response to transitory
changes in income.”
Permanent Income Hypothesis Consumption Function
C = k Yp
Where, Yp is the permanent income, C is the permanent consumption and k is the
proportion of permanent income that is consumed and is dependent on below:
1). Rate of interest: Higher rate of interest lead to lower consumption and vice versa.
2). Ratio of non-human wealth to human wealth: Higher the ratio or higher non-
human income greater the consumption.
3). Individual desire to create wealth: Higher desire to create wealth leads to lower
consumption and vice versa.
Graphical Presentation of Permanent Income Hypothesis
In short run consumption function is linear and non-proportional, i.e., APC > MPC and
the long run consumption function is linear and proportional, i.e., APC = MPC.
In Figure 2.14, S1 is the non-proportional short run consumption function where
measured income includes both permanent and transitory components. L1 is the long-
run consumption function which represents the long-run proportional relationship
between consumption and income of an individual.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
71
Figure 2.14 Permanent Income Hypothesis
At OY1 income level where S1 and L1 curves coincide at point M1, permanent income
and measured income are identical and so are permanent and measured consumption as
shown by Y1M1. At point M1, the transitory factors are non-existent. If the consumer’s
income increases to OY2 she/he will increase her/his consumption consistent with the
rise in her/his income and move along the short run consumption function such that
her/his consumption is Y2M3, as the consumer is not yet certain of the change in income
she/he considers it transitory in nature and accordingly moves a point where her/his
APC would decline. However if the consumer learns that her/his change in income is
not transitory but permanent, there would be a shift in her/his consumption function
from S1 to S2 and her/his consumption level would be at Y2M2 i.e. at the intersection of
S2 with L1. As there are permanent changes to income the consumer would move long
the long run consumption function L1 where APC=MPC.
Shortcomings of Permanent Income Hypothesis
1). Ignores correlation between temporary income and consumption which can
significantly affect individual’s consumption pattern both in long and short run.
2). Average consumption of different social groups is not same. Rich individuals will
have lower APC compared to poor individuals.
3). No clear distinction between human and non-human wealth.
4). Expectation are forward looking in nature not backward looking.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
72
2.4 OTHER THEORIES OF CONSUMPTION
2.4.1 Consumption Under Uncertainty: Robert E. Hall’s Random-
Walk Hypothesis
Noted Economist, Robert E. Hall, established a
new theory of consumption “Stochastic
Implications of the Life-cycle – Permanent
Income Hypothesis: Theory and Evidence”
(1978) by combining the “uncertainty of income
to life-cycle and permanent income hypothesis.”
His theory is known as “modern version of Life-
Cycle (LC) and Permanent Income (PI)
hypothesis (LC – PI hypothesis)” and is also
referred as the “Random Walk Theory of
Consumption.” The Ando-Modigliani’s life-cycle hypothesis and Friedman’s
permanent income hypothesis assumes certainty of income. However, according to
Hall, predicting life-cycle income and permanent income with certainty in reality is not
possible. There is an uncertainty about the future income.
Robert Hall was the first to indicate the rational expectations for consumption. Hall
questioned the accuracy of rational expectations and the life-cycle
hypothesis/permanent income hypothesis. He clarified that if this was true in reality,
then consumers would want an even consumption over time with less volatility. Hence,
if consumers have these rational expectations on a smooth consumption, then
consumers would use all available information when forming these expectations. If
both were true, then current consumption would resonate the consumer’s best estimate
of her/his available lifetime resources. Any changes in consumption should only be
related to the “surprises” about lifetime income. Surprises, is the information that was
non-existent at the time of planning and has been made available recently and is
material enough to impact the consumer’s consumption. For example, an unexpected
promotion in a job will increase consumption, and vice versa. In other words, alterations
in consumption should only reflect “surprises” about lifetime income. If consumers are
using all information to set expectations for consumption, then only the completely
unpredictable events should surprise them and change their consumption pattern.
Hence, changes in consumption should also be unforeseeable.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
73
The equation for future consumption is
Ct+1 = Ct + ǫt+1
In this equation, ǫt+1 is a rational expectations error that cannot be predicted with any
information known at time-t. All time-t information is reflected in current consumption,
Ct. The random walk characteristic of consumption is seen by writing
Ct+1 − Ct = ǫt+1
Consumption is a random walk, as changes over time are unforeseeable.
Evaluating the Random Walk Hypothesis
Over the past 3 decades, there has been extensive research on testing this hypothesis.
In their testing, researchers identify a group of people who are expecting a future
increase in income and then determine if the income changes lead to changes in
consumption at the same time. Hall’s hypothesis predicts that in these groups’ changes
in consumption should not occur as the income changes are foreseeable and hence the
consumer pre-adjusts her/his expenditure based on rational expectations. The results of
these tests are mixed, they have shown if there are large predictable Y (income) changes
then consumers usually pre-adjust C (consumption). However, if there are small
predictable Y changes, then consumers usually do not pre-adjust C.
2.4.2 David Laibson and the Pull of Instant Gratification
All theories from Fisher to Hall are based on the
assumption that consumers are rational and they act to
maximize the lifetime utility. Lately, economists have
also looked into psychology to further understand
consumer behaviour. They have suggested that
decisions on consumption are not undertaken by
extremely rational homo economicus, instead, they are
taken by real human beings whose behaviour can be
far from rational. Laibson points that many consumers
consider themselves to be poor decision-makers. Prof.
Laibson has integrated the insights from psychology into the study of consumption.
According to him preferences of consumers’ may be time-inconsistent: their decisions
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
74
may changes simply because time passes. One of these insights is that people’s
preferences are often dynamically inconsistent. This model of human behaviour formed
the base for all the work on consumption theory from Irving Fisher to Robert Hall.
Dynamically Inconsistent Preferences
Consider a student who is in Grade 10:
At 10:00 p.m., she/he sets the alarm clock for 8:00 a.m., the next day’s class so that
she/he will make it to class on time.
When its 8:00 a.m., she/he turns off the alarm and goes back to sleep. Why?
One explanation: She/he changed her/his decision based on some new information
during the night.
Likely explanation: What appeared rational at 10:00 p.m. — waking up early — was
invalidated at 8:00 a.m.
Preferences displayed dynamic inconsistency – they changed simply because of the
passage of time.
These kinds of behaviour are frequently observed in life. In a survey, 76% people said
they were not saving enough for retirement. Laibson ascribes this to the “Pull of Instant
Gratification”, which explains why people don’t save as much as they would if they
were perfectly rational and would save to maximize lifetime utility. The possibility of
dynamically inconsistent preferences explains that consumers may have self-control
problems, for example: People need an exercise partner to encourage themselves to go
to the gym, people avoid keeping tortilla chips in the house to control junk food, etc.
“Pull of instant gratification” can also be gauged from the following two questions
around time inconsistency.
Q1. Would you prefer (A) a candy today, or (B) two candies tomorrow?
Q2. Would you prefer (A) a candy in 50 days or (B) two candies in 51 days?
In studies, most people chose (A) for Q1 and (B) for Q2. People confronted with Q2
today, may choose (B). But after 50 days, when asked Q1, the pull of instant
gratification may tempt them to change their answer to (A).
These observations raise various questions and provide a new agenda for research.
CONSUMPTION FUNCTION: CONCEPTUAL ISSUES AND THEORIES
75
2.5 CONCLUSION
In this chapter we have discussed the work of eight prominent economists on consumer
behaviour ranging from Keynes’ Psychological Law of Consumption to David Laibson
Pull of Instant Gratification. Summarized below are the key takeaways from each of
these theories.
According to Keynes consumption is largely a function of current income. Keynes
focused on current income only and disregarded the importance of any other factor.
Economists argued against this saying that consumption is not only the function of
current income but also of wealth, expected future income, interest rates, etc. There has
been constant debate among economists as to which of the above factors helps to best
predict the consumption behaviour. Arguments have ranged from the impact of interest
rates on consumption, the presence of borrowing constraints and importance of
behavioural effects. Consumption is an important determinant of any economic policy,
like impact of increase or decrease in government debt or investment depends upon its
impact on consumer spending. The fact that the importance of consumption cannot be
undermined in any policy decision, this subject will continue to attract economists for
years to come.
•Consumption depends on Current Income Keynes
•Consumption in addition to income depends on other factors also.
Drift Theory
•Consumption depends on demonstration effect and ratchet effect.
Relative Income
•Consumption depends on the present value of lifetime income.
Irving Fisher
•Consumption depends on resources available i.e., income and wealth.
Life Cycle
•Consumption depends on long term expected income rather than current level of income.
Permanent Income
•Consumption depends upon current consumption plus future uncertainities.
Random Walk
•Consumption decisions are time inconsistent i.e., change with passage of time.
Pull of Instant Gratification